Thursday, October 25, 2012

The following is a rare open forum for one of the greatest minds in finance today to discuss his thoughts on the world and take questions from the audience. Hugh Hendry has become a hedge fund legend over the past few years as he has continued to make money during good times and bad (he remarks briefly on the 50% he made during just the month of October 2008 - the month most hedge funds lost 30% or more of their total value).

The Hendry portion of the video lasts about 22 minutes and if you fast forward to the 55 minute mark there is an interview with a second hedge fund titan: David Einhorn (another household name on this website). Einhorn famously challenged the balance sheet of a major bank back in 2008. The bank's name was Lehman Brothers. I'm sure you have heard who ended up winning the challenge as Einhorn took his short position on Lehman down to $0.0.

Yesterday we looked at the wave structure of bonds and gold and where they can be found in their current secular bull market. For a review see Two Intersecting Bubbles: Future & Present - Gold & Bonds. The following chart summarizes this discussion in perfect visual form showing bonds entering the manic blow off stage where prices relative to value (and supply) have left the stratosphere. This is the point of maximum danger in ownership of an asset class.

The chart also shows where gold stands in its secular bull market. After a 12 year run of continuous strong returns it will soon move out of the "awareness" phase of the cycle into the "mania" stage as the public finally enters the market (as they always do during the final stage).

When an investor understands this natural flow of a secular market cycle they have the ability to visualize where all the asset classes around them are located within the cycle. An investor's mental picture of the markets should look more like the following. A continuous stream of asset classes entering a blow off stage with a new market bottoming and beginning its secular journey.

What is the benefit of understanding this process?

These secular markets last on average between 15 - 20 years. This makes investing a far easier process than most people imagine. There is no need to "day trade" or try to monitor a screen 24 hours a day to stay on top of where an asset class will be every 15 minutes.

I purchased my first ounce of gold at $560 and my first ounce of silver at $7.60. I made these purchases over 7 years ago after spending about a year studying financial market history, the boom/bust psychology involved in markets, and learning how markets repeat on a long term secular cycle.

I remember reading professionals at the time who said the secular bull market in precious metals would likely not end until sometime between 2015 and 2020 (based on the historical 15 to 20 year trend). After learning how paper money was backed by nothing, governments were bankrupt, and the economy was headed over a cliff, it seemed almost impossible for it to take that long for the world to understand what was happening and shift a portion of their assets into precious metals.

But here we are 7 years later and we are still in the process of "awareness." This boom/bust cycle is due almost exclusively to just two main factors:

1. The Federal Reserve's involvement in the financial markets creating temporary misallocation of capital that would not exist in a free market structure. As oceans of cheaply borrowed or printed currency rush from one asset class to the next it creates the boom and subsequent bust.

2. There is absolutely no financial education taught in the public education system. I left college with a four year degree and was never once taught about how to invest money, market cycles, etc. I did receive Economic textbooks trying to teach Keynesian economics. I was fortunate that I paid little attention to those poisonous books during school (due to distractions), and I was able to begin my study of finance and economics after graduating.

With this understanding in mind let's bring it full circle. We know that bonds are closing in on the peak of their mania and gold is preparing to begin its multi-year mania stage.

How about stocks?

The following graph shows the ratio of US stock prices to average earnings for the preceding 10 years. This is known as a price to earnings ratio (P/E ratio) and it is the most popular tool used to determine the under or over valuation of stock prices. In other words, what are investors willing to pay for stock earnings? If they are willing to pay more for stock earnings then P/E ratios rise; it is a clear determinant of market psychology and sentiment.

The orange line running through the center of the graph shows the historical average P/E ratio. You can see that other than a brief moment in early 2009, stocks have been "expensive" since the early 1990's. Right around 1996 is when they entered the mania stage of the most recent secular bull market which ended in March 2000. Since then stocks have been stair stepping their way lower in terms of price to earnings as investors slowly lose faith in the asset class. This is how cycles work on the way up and the way down.

Market bottoms occur with P/E ratios under 10, as seen in the late 1970's and early 1980's. We will get there again before this market reaches a bottom. It just takes time for the madness of crowds to wash itself clean of the euphoria which is still echoing from the 1990's. This moment, when investors throw in the towel and declare they will "never buy stocks again," will represent one of the greatest stock buying moments in history.

When will this occur? The current secular bear market began in March of 2000. Stocks tend to run on secular cycles every 17.6 years, setting the current bear market to end around 2017 - 2018.

How about real estate?

Real estate began a secular bull market in 1991 lasting through 2006; a 15 year run. It has been in a secular bear market now for 6 years, and it most likely has a few more years to run in order to clear inventory and have maximum pessimism enter the market (psychology of renting vs. buying which is already in full swing). Will real estate bottom before stocks? I have no idea, but they are both fully dependent on the continuation of the bond bubble (low interest rates) making it appear that they may bottom together.

Wednesday, October 24, 2012

The following easy to understand video walks investors, using pictures and narration, through two of my personal favorite topics in finance: market psychology and history. It then takes those ideas and extrapolates them forward to our world today showing where we are in two key bubbles: bonds and gold.

The author feels that one of those asset classes is at the final stages of the mania period, meaning it is very close to the point of free fall in prices, and the other asset is very close to the beginning of its mania stage; the period during a bull market where the greatest gains are experienced in the shortest amount of time.

While I will not spoil the presentation, I'll give a hint to long time readers of this site: I agree with his analysis completely.

If you are someone that owns a significant portion of your retirement funds in bonds (perhaps through your 401k) and owns a very small, or 0%, of your retirement funds in gold - the following is a must watch.

Tuesday, October 23, 2012

Jim Rickards opened the first chapter of his excellent book Currency Wars discussing his involvement in a financial war game simulation created by the American government.

The following example is different from the strategy he used in the government simulation, but it is much more realistic based on the current state of the geo-political and financial world we live in today.

It shows the importance of understanding that the United States strength is found not only in their highly discussed military power, but the amount of physical tonnes of gold it holds in reserves. China finds itself in the exact opposite situation and has most likely already begun, or will soon begin, scrambling to catch up with other countries around the world in total gold reserves.

Incredible walk through that shows the speed in which the currently calm currency wars taking place around the world can escalate quickly. Remember that no currency in the world has a currency backed by gold. For the first time in history, every single country is issuing (a tremendous amount) of worthless paper money backed by nothing. There will be a day when these paper bills are revalued to reflect the amount of currency that has digitally been created. It will come swiftly and suddenly and catch most by surprise.

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.